The Relationship Between Consolidation and Innovation in the Drug Industry

The prescription drug industry has undergone a significant transformation in recent decades. The intensifying competition from generic drugs, the expanding power of entities that pay for drugs and negotiate drug prices, the increasing costs of drug development and gaining approval from the Food and Drug Administration, and the growing risks of commercial failure have strained the finances of many traditional drug companies. Many companies have responded by consolidating to either reduce costs or create new sources of revenue. As a result, the number of mergers and acquisitions (M&A) in the pharmaceutical industry recently hit an all-time high.

As pharmaceutical M&A has soared, so too has concern over the impacts of consolidation on the drug industry. While most of the scrutiny has focused on the potential harm to existing competition, researchers and regulatory agencies have also raised less-traditional concerns about harms to future innovation in the newly-merged firms. These concerns are premised on the idea that merging competitors into one firm will reduce incentives to develop new drugs. Merger analyses in innovative industries other than the drug industry are also increasingly incorporating innovation effects. In fact, three of the largest proposed mergers today— Monsanto/Bayer, Dow/Dupont, and ChinaChem/Syngenta—have faced scrutiny in both the U.S. and Europe over concerns that the mergers will slow innovation in agricultural biotechnology.

However, as I explain in my recent article, “Consolidation and Innovation in the Pharmaceutical Industry: The Role of Mergers and Acquisitions in the Current Innovation Ecosystem,” concerns about consolidation’s impact on drug innovation are largely based on an outdated understanding of the innovation ecosystem in the pharmaceutical industry. Today, most drug innovation originates not in traditional pharmaceutical companies but in biotech companies and smaller firms, where a culture of nimble decision-making and risk-taking facilitates discovery and innovation. In fact, about two-thirds of New Molecular Entities approved by the FDA originate in biotech and small pharmaceutical companies, and these companies account for almost 70 percent of the current global pipeline of drugs under development.

To complete the development process and commercialize their drugs, biotech companies regularly collaborate with large pharmaceutical companies that push drugs through the grueling late-stage clinical trials and regulatory hurdles of the FDA, organize their manufacturing and distribution capabilities to bring the drugs to market, and mobilize their vast sales force to quickly achieve peak sales. In this current ecosystem, each biotech and pharmaceutical firm can specialize in what it does best, bringing expertise and efficiencies to the innovation process.

This specialization has dramatically changed the share of internally-developed versus externally-developed drugs in the pharmaceutical industry. Whereas in the 1970s and early 1980s, almost all drug discovery and early stage development took place inside traditional drug companies, today, the companies increasingly shift resources away from internal R&D expenditures and projects and towards external sources of innovation. Externally-sourced drugs now account for an incredible 74 percent of new drugs registered with the FDA for sale in the U.S. Internal R&D is no longer the primary source of drug innovation in large pharmaceutical companies.

As a result, antitrust analyses that focus on pharmaceutical mergers’ impacts on internal R&D and innovation largely miss the point. In the current innovation ecosystem, where little drug innovation originates internally, a merger’s impact on internal R&D expenditures or development projects is often immaterial to aggregate drug innovation. Certainly, concerns about harm to innovation could be relevant in specific mergers or acquisitions if the consolidating firms are the primary innovators in an area, the firms innovate internally, and there are limited sources of external innovation. However, such scenarios are increasingly rare in the drug industry.

Instead, proper analyses of the impacts of consolidation on innovation should focus on whether consolidation enables firms to better support aggregate drug innovation in the current innovation ecosystem. In many consolidated firms, increases in efficiency and streamlining of operations free up money and resources to acquire external innovation. The resulting boost in demand for externally-sourced innovation increases the prices of external assets, which, in turn, encourages more early-stage innovation in small firms and biotech companies. Aggregate drug innovation increases in the process.

Drug industry analysts expect the already heightened pace of M&A activity to pick up under the Trump administration, as stock prices rise and proposed tax reforms encourage deal-making. Policymakers must understand the role of consolidation in the current innovation ecosystem and evaluate mergers for their likely impacts on aggregate drug innovation.

This post comes to us from Professor Joanna Shepherd at Emory University School of Law. It is based on her recent article, “Consolidation and Innovation in the Pharmaceutical Industry: The Role of Mergers and Acquisitions in the Current Innovation Ecosystem,” available here.